The right protection can shield you and your family from difficult life events, ensuring that you’re able to remain financially stable and work towards your goals.
For example, a critical illness cover policy could provide a lump sum to help you pay for treatment costs, your mortgage, or general living expenses if you’re diagnosed with a qualifying medical condition.
Alternatively, if you pass away, your family could use the lump sum from a life insurance payout to clear the mortgage or cover their monthly outgoings. They might also contribute to pensions and other savings for the future, meaning they may be more likely to reach their long-term goals.
Unfortunately, many families lose a portion of their life insurance lump sum to Inheritance Tax (IHT) because the funds form part of the deceased’s estate for tax purposes. Indeed, according to Actuarial Post, 6,810 of the estates that paid IHT in the 2021/22 tax year included life insurance policies.
Yet, if you place your protection policy in a trust – a legal arrangement that allows you to pass assets to another person, for the benefit of a third party – you might be able to reduce the tax you and your family pay.
There are other potential benefits to placing protection in a trust too. However, these arrangements can be quite complex, and you may have queries about how the process works and what the benefits are.
Read on for the answers to three important questions about protection and trusts.
1. What different types of trust can I use?
When you place a protection policy in a trust, you pass it to “trustees” who manage it on your behalf. Once placed in a trust, you no longer own the policy, and any benefits paid out typically don’t form part of your estate for tax purposes.
You can then choose “beneficiaries” who will eventually benefit from the asset. In this case, the beneficiaries are the people who will receive the payments from the protection policy.
There are several different types of trusts, each with unique rules and limitations to consider. Below are details of some of the trusts most commonly used for life insurance policies:
- Discretionary trust – This is the most flexible type of trust as the trustees can choose from a range of beneficiaries. For instance, if you pass away, they might decide whether your spouse or civil partner, children, or other family members should receive the life insurance payout.
- Absolute or “bare” trust – Unlike a discretionary trust, the beneficiaries of the policy are chosen on setting up the trust and can’t be changed later.
- Survivor’s discretionary trust – This type of trust is used for joint policies. In the event of one person’s death, the surviving policy holder receives the payout after 30 days. However, if the surviving policy holder also dies within those 30 days, the beneficiaries of the trust receive the payout.
It’s important to consider which type of trust will be most suitable for your unique situation. You may want to seek professional advice to ensure that you are being as tax-efficient as possible and your beneficiaries can access the funds when they need them.
2. What are the benefits of putting protection in a trust?
One of the key benefits of putting protection, particularly life insurance, in a trust is that it could reduce the IHT your family pays when you pass away.
In 2024/25, you can pass on up to £325,000 without IHT. This is known as your “nil-rate band”. You may also benefit from an additional “residence nil-rate band” of up to £175,000 when passing your main home to a direct descendant such as a child or grandchild.
Additionally, you can pass your entire estate to a spouse or civil partner without IHT and they inherit your unused nil-rate bands. As such, couples may be able to pass on up to £1 million before IHT is due.
Any wealth that exceeds the nil-rate bands is typically subject to IHT at a rate of 40%.
Normally, if your life insurance policy isn’t in trust, the payout is made to your estate. Your beneficiaries will then inherit the wealth along with anything else you pass on to them. This means that the lump sum is included in IHT calculations.
Conversely, if you place the policy in a trust, it doesn’t normally form part of your estate. Instead, when you pass away, the lump sum is paid directly to your beneficiaries from the trust. As a result, your family may be less likely to pay IHT on the proceeds from your life insurance policy.
This may be more beneficial in the future as chancellor Rachel Reeves recently announced in her Budget that pensions would no longer be exempt from IHT after April 2027. The nil-rate bands are also frozen until 2030, while the value of your estate could increase if house prices rise or you generate returns on savings and investments.
All this means a larger portion of your estate could exceed the nil-rate bands in the future, and your family could pay more IHT as a result. Fortunately, placing your life insurance in a trust could protect a portion of your wealth and your loved ones could use these funds to help pay a large tax bill.
Additionally, as the protection payout never forms part of your estate, your beneficiaries don’t need to wait until probate – the legal process of administering your estate – is complete before they receive the funds.
Normally, your loved ones can’t apply for probate until any outstanding IHT is paid. By putting the policy in a trust, your loved ones can receive the payout and potentially use it to pay an IHT bill, meaning they can apply for probate and access wealth from the rest of your estate.
Consequently, they could benefit from this vital safety net much sooner, meaning they can remain financially stable during a difficult time.
3. Are there any disadvantages to putting protection in a trust?
While putting protection in a trust could speed up the payments and potentially reduce the IHT your loved ones pay, there are potential downsides to consider.
Most importantly, you can’t reverse your decision once you’ve placed the policy in a trust. Depending on the type of trust you have used, you might not be able to make changes to the policy either, and this could lead to complications.
For instance, if you named your spouse or civil partner as a beneficiary and later separated, you may not be able to remove them from the policy. Even if you use a discretionary trust that does allow you to make changes, all trustees will need to sign off on any amendments.
Consequently, conflicts and disagreements between trustees can make it difficult to change your policy.
That’s why it’s important to seek professional advice and ensure that you have considered all eventualities before setting up a trust.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning, tax planning, or trusts.
Note that financial protection plans typically have no cash in value at any time and cover will cease at the end of the term. If premiums stop, then cover will lapse.
Cover is subject to terms and conditions and may have exclusions. Definitions of illnesses vary from product provider and will be explained within the policy documentation.